Any business knows that debt-to-equity ratios serve as an important metric for success. This number represents more than your financial stability – it also increases how reputable and attractive your business is to investors. But achieving a good debt-to-equity ratio can be tricky, especially if you’re in the early years of operation.

Although financial stability may take years to achieve, there are some tips that all businesses can do today to help.

What Is the Debt-to-Equity Ratio?

The debt-to-equity ratio is a metric that accesses a company’s financial leverage. In most cases, this is how much debt the company has taken on compared to how much equity they have from shareholders. In other words, can the company operate and meet financial obligations using the funds it currently has?

A good debt-to-equity ratio means yes – the company is using its money wisely. They aren’t spending a whole lot more than what they are making. But if they have a poor debt-to-equity ratio, then they may have trouble with sustainability, hiring, or even securing investors. Therefore, companies should aim to have a low debt-to-equity ratio.

How Is the Debt-to-Equity Ratio Calculated?

When calculating the debt-to-equity ratio, you will need to divide the amount used for company liabilities by the amount of shareholder equity. Shareholder equity is determined after all the short- and long-term liabilities have been deducted from the total assets. Usually, this is all calculated on your balance sheet, but it’s also useful to understand the formula.

Here’s an example:

Let’s say your company has $500,000 in liabilities and $400,000 in shareholder equity. Using the above formula (500,000/400,000), you will get a debt-to-equity ratio of 1.25.

This means for every dollar of equity, the company will have accrued $1.25 in debt. In this example, our company has a fantastic debt-to-equity ratio!

What Are Good or Bad Debt-to-Equity Ratios?

This is a tough question to answer as different industries have different standards. However, the lower the debt-to-equity ratio, the better. Some companies believe falling between 1 and 1.5 is a good ratio, while others believe anything under 2 is sufficient.

A higher ratio is often associated with a company being a higher risk. That means they take on more debt than they own and run the risk of not being able to pay back the loan. While this is sometimes different to avoid during the start-up phase, companies should generally aim to have a low ratio.

Best Practices for a Good Debt-to-Equity Ratio

Don’t Take on Too Much Debt

This may be a no-brainer, but if you want to have low debt-to-equity ratios, don’t take on extra debt. Loans can quickly deplete your funds or cash reserve. Instead of taking on debt, consider other ways to raise money.

One of the easiest ways to do this is through equity financing or issuing new shares. Because there isn’t any interest or repayment involved, you won’t have to worry about accruing additional debt.

Pay Off Debt

Having a lot of debt will inevitably increase your company’s debt-to-equity ratio. To lower this figure, make paying off your current debt a priority. This is especially true if you’re locked into a loan with a high interest rate. These additional fees can quickly add up and drain your cash reserve.

If you’re lucky enough to have a low interest rate, this won’t affect your savings as much. But you should still try to pay off the debt if the goal is to lower your debt-to-equity ratio.

Restructure Current Debt

If you can’t pay off your debt, you may still be able to restructure the existing terms with the lender. This could be to take advantage of lower interest rates or extended loan times. Those with high-interest loans may also look at switching to a fixed-rate loan. This will protect your business from any increases in interest (which is good for cash flow and financial forecasting!) If you have taken out multiple loans, you may also have the option to consolidate your debts into a single payment.

Keep in mind that restructuring your debt may have certain tax implications. We highly recommend working with a tax professional (whether you’re a business or an individual) to minimize your tax liabilities.

Increase Revenue

Every company wants to make more money, but this is sometimes easier said than done. However, higher revenue translates to higher profits, which increases the value of shareholder equity. Depending on your product or service, there are many different ways to increase revenue. B2B companies may consider new people-focused marketing strategies, while small businesses should focus on partnerships and client growth.

Manage Current and Incoming Inventory

The amount of money you spend on inventory can take a big toll on your profitability. Dealing with unnecessary or outdated inventory can be very expensive to manage or maintain. Instead, look for ways to reduce costs and free up the funds to help pay off your debts.

Here are some ways to do this:

• Only order inventory when needed. Do not stockpile.
• Use historical data to forecast demand
• Build connections with strong suppliers and look for discounts

Keeping track of your budget and financials is key to staying organized and in the green. By monitoring your inventory cash flow, you can make better decisions for your company in the short- and long-term.

Securing a good debt-to-equity won’t happen overnight. It can take years to lower the debt to become profitable. But it’s worth the discipline and planning to do so, as it improves investor confidence and makes your company more sustainable in the long run. If you’re just in the early stages of starting a business, then this is still good information to remember. It’s never too early to start planning for financial success!